Why Congress should not extend unemployment benefits

President Obama wants Congress to again extend unemployment benefits. That's a hard request to resist, politically. But the economic impact of extending jobless benefits is that wages will not fall quickly enough to create more jobs.

John Maynard Keynes argued that recessions are prolonged by wages falling much more slowly than assumed in the models of classical economics. Virtually all economists agree with this point. Like most economists, then and now, Keynes believed that if wages could fall very rapidly, labor markets would clear quickly and therefore unemployment would be short-lived.

Rapidly falling wages produce jobs

For this reason, Keynesian and nonKeynesian economists alike view the speed at which wages fall in a recession to be important for rapid economic recovery. Falling wages increase the profitability of production, and this induces firms to produce more. This in turn leads to more hiring, faster economic growth, and a lower unemployment rate.

The most obvious way for wages to fall is for individuals to be paid less in the jobs they already have. Although some companies have introduced pay cuts, there are strong institutional impediments to doing so, and therefore most have not. But another way the economy can produce the same effect is if individuals, after losing a job, take new jobs at lower wages than the jobs they originally had.

What does this have to do with extending unemployment benefits?

Someone who is unemployed as a mechanical engineer might nevertheless be able to find a job as a production line worker. Extending unemployment benefits induces such an individual to keep looking for another engineering job. But if that individual took a job as a production line worker because unemployment benefits ran out, productivity in the new position would almost certainly increase – even though the wage associated with it did not rise.

Extending jobless benefits makes wages rigid

Because extending unemployment benefits makes many individuals less willing to take new jobs at lower pay, it adds to wage rigidity, which Keynes (correctly) argued prolongs recessions.

There is abundant empirical evidence that unemployment benefits induce workers to keep looking for a job like the one they lost (see previous work by Alan Krueger, the president’s new top economic advisor). So extending unemployment benefits yet again will interrupt a potentially important mechanism by which the economy self-corrects by effectively reducing real wages.

Why is this so hard to see? Most economists and federal government officials are acting as if the current bad economy follows the standard Keynesian scenario: consumption and investment spending fall for no good reason, causing output and employment to fall below a sustainable trend. Since it takes needlessly long to return to the trend, it is sensible to stimulate the economy to hasten the recovery.

But what if the original problem was excessive monetary and fiscal stimulus that led to a credit boom, an asset bubble, and therefore a level of consumption that was above the sustainable trend? This well describes the recession we are still struggling to fully put behind us. In this case, stimulating the economy to return to an unsustainable trend is not a viable long-run solution.

The ultimate answer is consuming less and/or working more as a nation. This is precisely what an actual or de facto decrease in wages does. Once the economy returns to a sustainable production and consumption trend, uncertainty will diminish as markets stabilize. This will induce entrepreneurs to get back to work on inventing new products and production methods. The increases in genuine productivity that result from this process are the real source of increasing prosperity over time.

The politics of rejecting an extension in jobless benefits

There is simply no evidence to support the claim that extending unemployment benefits hastens recovery by propping up consumer spending. The unemployment rate is still 9.1 percent, and the economy is growing much more slowly at this stage of the recovery than is typical of business cycles. Why continue down the same path when there is a good theoretical explanation for why that path will fail?

There is abundant evidence that when unemployment benefits run out, people do find jobs – just not the jobs they had before. Conversely, extending unemployment benefits subsidizes longer searches to find jobs like the ones that were lost. Meanwhile, such individuals are not working with others to make new goods, so the amount of goods produced is lower. This prolongs the unemployment of others.

We need to stop focusing on the suffering of those whose unemployment benefits run out, and start focusing on people who will become unemployed or be unemployed longer because of the unwillingness of those who are able to find lower paying jobs, to take those jobs.